An alternative approach on pay for success

Social Impact Guarantee deserves a test

EIGHT YEARS AGO, I pitched the pay for success concept as a new kind of money-back guarantee. Government would pay for a social service, impact would be rigorously measured, and, if impact fell short, government would get its money back. Think of it as impact insurance, or a Social Impact Guarantee – SIG for short.

A couple of years later, Social Finance UK came up independently with a different approach. Instead of offering a money-back guarantee, they invented the Social Impact Bond (or SIB). With the SIB, government would pay for social services on a delayed basis, but only after impact was achieved. To cover the timing gap, private funders (not government) offered loans upfront to pay for services. Then, once government paid, the private funders could get their loans back, plus interest.

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Both of these approaches – the Social Impact Guarantee and the Social Impact Bond – get to a similar place: government pays only if social impact is achieved. In other words, they both enable Pay for Success contracting. And both use private financing to offload performance risk from vulnerable service providers. The Social Impact Bond approach is now being utilized in numerous jurisdictions across the country, but the Social Impact Guarantee has remained largely theoretical. I think it’s time that changed, largely because the SIG approach can be simpler and philosophically more intuitive than the SIB.

One of the reasons that SIBs can be so difficult to implement is that government is not accustomed to contracting for social services in a multi-year or contingent way. Thus, even if government officials would like to take on multi-year SIB loan obligations, laws and regulations may be a barrier.

There are workarounds to these laws and regulations – waiver processes, legislative overrides, creation of special new spending streams with special use rules, elaborate sinking funds, and the like. But the workarounds are technical, expensive, uncertain, and time consuming. Indeed, this has been a significant impediment to the growth of pay for success contracting.

A second technical problem with SIBs is called “double capitalization.” Originally, the idea was to relieve stress on government cash flows by providing private upfront SIB financing. In practice, governments have been making advance appropriations or placing capital into escrow accounts right from the start, so that private funders will feel confident that the money will be there in the future for government to make pay for success payments. This “double capitalization” has been necessary to give funders confidence in initial projects, but it is an inefficient way to scale Pay for Success contracting more broadly.

With the Social Impact Guarantee, the model is flipped: Instead of government, it is the private funders who make a contingent promise to pay in the future based on impact. Thus, government purchases social services in a way that more closely resembles its usual pay-as-the-work-is-done timing. Then, if social impact targets are missed, the private funders write a check back to government. For example, a group of private SIG funders might obligate themselves today to write a check to the state of Connecticut three years from now, but only if a program fails to reduce the prison-going rate. The good news is that multi-year contingent promises are something private funders do all the time. No waivers needed, no new government spending streams with special rules. It’s just a lot simpler.

The other good news is that the Social Impact Guarantee model will use letters of credit rather than upfront cash as its way to guarantee payment promises. In other words, there are no escrow accounts with money just sitting there, doing nothing. Bottom line, the SIG would have less “double capitalization” than the SIB, and that means it is inherently less expensive.

Philosophically, I have felt that the SIB places too much emphasis on borrowing and not enough on insurance. Indeed, the central role of a SIB (and certainly of a SIG) is insurance. It insures against the risk of government allocating precious taxpayer money to programs that do not work. And it insures vulnerable nonprofit service providers against the financial peril of potentially never being paid.

Perhaps because SIBs are most often positioned as a lending product, people immediately begin to ask whether government really needs to borrow more money, and they ask why the 5 percent interest rates are so much higher than, say, municipal bonds.

With the SIG, everything begins to make more sense. It is not an interest payment; it is an insurance premium. And it is easy to explain how paying a 5 percent premium for something that might pay back 100 percent is a good deal, especially in a world where so many social programs, when rigorously evaluated, are revealed to have been ineffective.

Of course, as with any innovation, the SIG model brings unique challenges. For example, it is not always easy to work out precisely where in government the payments will go if it turns out that a SIG guarantor has to write a check. There will be other challenges as well, but so far they seem to be considerably less onerous than the challenges we have dealt with while implementing SIBs.

At Third Sector Capital Partners, Inc., we believe that the SIG holds more than enough potential to merit testing, as it promises to simplify the contracting process, lower project costs for governments, and tap into the immense world of mainstream insurance. Ultimately, we believe it could enable pay for success contracting to scale more rapidly, thus empowering more governments to pursue outcomes-based contracting that measurably improves the lives of our most vulnerable citizens.

Third Sector Capital Partners, Inc. will most certainly continue to embrace Social Impact Bonds, as they remain the de facto vehicle for financing pay for success projects in the United States. That said, it is our goal to pursue and to implement the world’s first SIG-financed project this year.

George Overholser is the CEO and cofounder of Third Sector Capital Partners Inc. of Boston.